Economics 324: Introduction: Interest Rates and Bond Prices
1. Function of interest rates
A. Interest rates provide a mechanism to allocate savings among alternative uses
1. Savers (lenders) are rewarded for postponing consumption
2. Spenders (borrowers) view interest rate as cost of borrowing funds
B. Interest rates link present values to future values
2. Inverse relationship between bond prices and interest rates (Pages 54-61; 65-67)
A. The yield to maturity, which is the measure that most accurately reflects the interest rate, is the interest rate that equates the present value of future payments of a debt instrument with its value today.
Application of this principle reveals that bond prices and interest rates are negatively (inversely) related.
See equation 2 on page 56, equation 3 on page 57, and equation 4 on page 58 on page 97 regarding general relationship between interest rates and present value where price of asset should equal present value of that asset).
See pages 60-61 for discussion regarding for relationship between interest rate and present value of coupon bonds, which U.S. government and many corporations issue.
1. When the interest rate rises, the price of existing bonds falls. Rising interest rates indicate falling bond prices.
2. When the interest rate falls, the price of existing bonds rises. Falling interest rates indicate rising bond prices.
B. Interest rate risk: Fluctuation in market prices of assets that occurs because interest rate changes. See pages 65-67 and Table: “The Relationship between the Market Interest Rate and the Bond Price” on page 66.
1. Prices and returns for long-term bonds are more volatile than prices and returns for shorter-term bonds (See Table 5.6 “Present Value of a $1,000 Bond When the Market Interest Rate Declines from 8 to 7 Percent” on page 97)
2. Long-term bond...